Chapter 7: The Selection of Fixed Value Investments: Second
and Third Principles

Principle 2: Bonds Should be Bought on a Depression Basis

Any bond can do well
when the
conditions are favorable; it is only under acid test of depression that
the
advantages of strong over weak issues become manifest and vitally
important.
Confidence in the ability of bond issue to weather depression may be
based
either on

a)Character
of the industry and the particular business will be immune from a
drastic
shrinkage in earning power. The distinction is between those which are
more and
less affected by depression. The more stable the type of enterprise,
the better
suited it is to bond financing and the larger the portion of the
supposed
normal earning power which may be consumed by interest charges. If
there is
such a lack of inherent stability as to make survival of the enterprise
doubtful under unfavorable conditions, then the bond issue cannot meet
the
requirements of fixed value investment, even though the margin of
safety,
measured by past performance, may be exceedingly large. Such a bond
will meet
the quantitative but not the qualitative test, but both are essential
to our
concept of investment.

b)The
margin of safety is so large that it can undergo such shrinkage without
resultant danger. The margin of safety would be dependent on the
character of
the industry.

Even though the
conditions
prevalent in the depression years may not be duplicated, the behavior
of
various types of securities at the time should throw a useful light on
investment problems.

Proper Theory of Bond
Financing:
A reasonable amount of funded debt is of advantage to a prosperous
business,
because the stockholders can earn a profit about interest charges
through the
use of the bond holder’s capital. It is desirable for both the
corporation and
the investor that the borrowing is limited to an amount which can
safely be
taken care of under all conditions.

Graham suggests that
an investor
should reconcile himself to accepting an unattractive yield from the
best bonds
rather than risking his principle in a second grade issue for the sake
of a
large coupon.

Principle 3: Unsound to Sacrifice Safety for Yield

In the traditional
theory of bond
investment a mathematical relationship is supposed to exist between the
interest rate and the degree of risk incurred. The interest return is
divided
into two components, the first constituting of pure interest –
the rate
obtainable with no risk of loss – and the second representing the
premium
obtained to compensate for the risk assumed. This theory assumes that
bond
interest rates measure the degree of risk on some reasonable precise
actuarial
basis. It would follow that, by and large, the return from high and low
yielding investments should tend to equalize, since what the former
gains in
income would be offset by their greater percentage of principal losses,
and
vice versa.

Graham does not
believe such a
mathematical relationship exists between yield and risk. Security
prices and
yields are not determined by any exact mathematical calculation but
they rather
depend upon the popularity of the issue. This popularity reflects in a
general
way the investor’s view as to the risk involved, but it is also
influenced
largely by other factors, such as the degree of familiarity of the
public with
the company and the issue and the ease with which the bond can be sold.

The relationship
between
different kinds of investments and the risk of loss is entirely too
indefinite
and to variable with changing conditions, to permit sound mathematical
formulation. This is particularly true because investment losses are
not
distributed fairly evenly in point of time, but tend to be concentrated
at
intervals, i.e. during periods of general depression.

The main objections
to
sacrificing safety for yield is that (a) such a policy requires wide
distribution of risk in order to minimize the influence of luck by
holding a
large number of different bonds and (b) more importantly the danger
that many
risky investments may collapse together in a depression period, so that
the
investor in high yielding issues will find a period of large income
followed
suddenly by a deluge of losses of principal.

The bond buyer is
neither
financially nor psychologically equipped to carry on extensive
transactions
involving setting up of reserves out of regular income to absorb losses
in
substantial amounts suffered at irregular intervals. Graham may not
have this
objection for say a fund manager who does not have these constraints.

Graham suggest that
while risk of
losing principal should not be accepted merely by a higher yielding
coupon, he
does not object to purchasing a bond at a substantial discount to par.
While
these are mathematically equivalent, the psychological difference is
important.
The purchaser of low priced bond is aware of the risk and is more
likely to
make a thorough investigation of the issue and carefully appraise the
chance of
profit and loss.

Graham suggests it
would be
sounder to start with definite standards of safety, which all bonds
must be
required to meet in order to be eligible for further consideration.
Issuing
failing to meet these minimum requirements should automatically be
disqualified
as straight investments regardless of high yield, attractive prospects,
or
other grounds. Essentially, bond selection should consist of working
upward
from definite minimum standards rather than working downward in
haphazard
fashion from some ideal but unacceptable level of maximum security.